Investing has always seemed more complicated than it really is.
This is partially because of the complicated language used to describe relatively straightforward concepts.
Exhibit A: “asset allocation.”
Exhibit B: “diversification.”
Asset allocation and diversification are not terms that come up in regular day-to-day conversation. That’s a good thing, btw.
Because of that, these terms don’t make immediate sense to somebody new to investing. That’s why I want to spend some time learning some basic investment language.
Then, you’ll appreciate how asset allocation and diversification are some of the best ways to minimize risk when investing.
We’ve already talked about a couple of the other main ways to minimize risk. One is to buy and hold for the long term, which I think of as investing early and often.
We’ve also looked at the importance of minimizing fees.
When you combine all three strategies, you’ll be setting yourself up for a very prosperous future.
So today, let’s talk about the importance of asset allocation and diversification.
To make better sense of what we mean by asset allocation and diversification, let’s first define some key terms.
What is a security?
The term security broadly includes any investment instrument, such as a stocks or bonds.
When you invest money in a company, you have a protected or “secured” claim on profits from that company.
What are stocks?
Stocks are a type of security that gives stockholders a share of ownership in a company. If you buy stock in a company, you own a small piece of that company.
Why would a company sell you an ownership piece?
Companies issue stock to get money for a variety of reasons, like developing new products or paying off debt. The basic idea is that by offering stocks, companies can thrive and make more money.
Stocks also are called “equities.”
Stocks have typically offered investors strong potential for growth over the long term. However, there’s no guarantee that you will earn a strong return. You can lose money when you invest in stocks.
What are bonds?
Bonds are like IOUs where you are lending money to an entity, like a company, government, or municipality.
These entities issue bonds to raise money from investors. In exchange, the issuer agrees to pay the investor interest during the life of the bond. The issuer also agrees to repay the principal (the original investment) after a set period of time.
Bonds are generally considered safer than stocks. Because bonds are a safer investment, you can expect a lower return on your investment.
What are mutual funds?
A mutual fund is a company that pools money from many investors and invests in securities, like stocks and bonds.
As an investor, you can buy shares in mutual funds. Each share represents your part ownership in the fund and the profits it generates.
Mutual funds typically invest in a variety of companies and industries. This helps minimize your risk as an investor. A mutual fund may have a combination of stocks and bonds, which also acts to minimize risk.
Mutual funds are usually professionally managed. That means managers do the work for you. But, that service comes with a price or “fee.”
The fee can be a significant drain on your investment earnings. We looked at the impact of even a 1% fee on your long term earnings here.
Mutual funds were very popular in the latter half of the 20th century, especially the 1980s and 1990s.
Nowadays, a subtype of mutual funds, known as “index funds,” has become a popular and advantageous option for most regular investors.
What are index funds?
An index fund is a type of mutual fund that seeks to track the returns of a market index, like the S&P 500 Index.
As explained by Vanguard:
An index mutual fund or ETF (exchange-traded fund) tracks the performance of a specific market benchmark—or “index,” like the popular S&P 500 Index—as closely as possible. That’s why you may hear people refer to indexing as a “passive” investment strategy.
Instead of hand-selecting which stocks or bonds the fund will hold, the fund’s manager buys all (or a representative sample) of the stocks or bonds in the index it tracks.
When we talk about investing in the S&P 500 Index, we mean investing in an index fund that tracks the returns of the S&P 500.
Index funds are typically passively managed, rather than actively managed. Index funds are focused on long term returns. Unlike an actively managed fund, index funds do not buy and sell securities frequently.
Because index fund are passively managed, their fees are significantly lower than actively managed mutual funds.
With these terms in mind, we can now talk about asset allocation and diversification.
What is asset allocation?
Asset allocation refers to dividing your investments among different options like stocks, bonds, and cash.
The optimal asset allocation varies from investor to investor.
Your optimal asset allocation will vary depending on where you are in your investment timeline. That’s because one of the biggest factors in asset allocation is an investor’s time horizon.
The longer the time horizon an investor has, the more risk that investor can afford to take on. That typically means investing more money in stocks.
Stocks usually offer a higher potential rate of return, but come with greater risk.
As an investor’s time horizon shrinks, it’s wise to invest less money in stocks and more in bonds. This safer approach acts to protect years of investment earnings from drastic losses later in life.
For these reasons, it’s important for investors to rebalance their portfolio as time goes on.
What do we mean by “rebalance”?
Let’s look at an example. Let’s say an investor’s optimal asset allocation is 50% stocks and 50% bonds. After a year of impressive stock market growth, this investor’s portfolio now consists of 60% stocks and 40% bonds.
As a result, he’s now weighted more heavily in stocks than his optimal asset allocation. To rebalance his portfolio, he could take a variety of steps. He could sell some stocks or purchase more bonds to get back to where he wants to be.
What is diversification?
Diversification refers to the act of spreading money around in different investments to decrease risk.
Think of diversification in two parts:
- First, it’s important to diversify among asset classes, like owning a combination of stocks and bonds.
- Next, it’s important to diversify within each asset class, like owning a variety of stocks instead of just one type of stock.
As for diversifying among asset classes, stocks and bonds generally have an inverse relationship. When one asset class does well, the other performs poorly.
By holding a combination of stocks and bonds in your portfolio, you can minimize the consequences of big drops in the market.
As for diversifying within asset classes, it’s generally recommended that investors own a variety of each type of asset.
For example, it is typically wise to own stocks of various companies and across different industries. That way, your investment returns are not determined by one small subset of the overall economy.
The S&P 500 and the Dow are the two most common stock indices.
When people talk about “the markets”, they’re typically talking about the S&P 500 or the Dow.
The S&P 500 is a broad stock market index that tracks the performance of about 500 large publicly traded companies in the United States.
Because it tracks companies from a wide variety of sectors, the S&P 500 is typically a good barometer for the entire U.S. (and world) economy.
This is all to say that if you choose to invest in an S&P 500 index fund, you essentially own a piece of 500 large companies.
That’s pretty good diversification.
The other most common index you’ll hear about is the Dow Jones Industrial Average (“Dow”). The Dow tracks 30 U.S. blue chip companies. You can invest in an index fund that tracks the Dow and essentially own 30 of America’s biggest and best companies.
In addition to these two major indices, investors have a variety of options to invest in index funds that track certain sectors of the economy.
You can also invest in an index fund that tracks the entire U.S. stock market. For example, Vanguard offers a popular fund called the Vanguard Total Stock Market Index Fund.
This fund provides exposure to nearly the entire U.S. stock market, which consists of 3,598 companies.
Now, that’s really good diversification.
Read The Simple Path to Wealth by J.L. Collins
One of my favorite authors on investing, J.L. Collins, wrote about the advantages of investing in a total stock market index fund in his seminal book, The Simple Path to Wealth.
In fact, Collins makes a compelling argument that the Vanguard Total Stock Market Index Fund may be the only stock fund that you’ll ever need.
I highly encourage you read The Simple Path to Wealth.
If all this sounds complicated, don’t worry.
I’ve told you before that investing is actually the easy part.
Now, I can explain why.
Index funds have become the go-to investment choice for most everyday investors. That’s because index funds are naturally diversified, meaning when you invest in an index fund, you own stock in every company that makes up that index.
Index funds are also passively managed, which means they have very low fees.
When you combine a diversified selection of stocks with low fees, you’re setting yourself up for success.
But hey, don’t take it from me.
Take it from the single greatest investor of our lifetimes, if not ever: Warren Buffett.
In 2013, Buffett famously instructed that after he dies, his wife’s money should be split 10% in short-term government bonds and “90% in a very low-cost S&P 500 index fund.”
Good enough for Buffett, good enough for me.
Don’t ignore target date retirement funds.
If this still seems too complicated, that’s OK.
There’s an even easier option available to all of us, at a very low cost, called target date retirement funds.
The idea behind a target date retirement fund is that your portfolio automatically rebalances as you move closer to retirement.
Over time, your portfolio will gradually reduce its exposure to stocks and increase its exposure to safer assets, like bonds.
You do not have to do a thing.
It simply cannot get any easier than this.
Most employer-sponsored retirement plans offer target date retirement funds as a low cost, low stress option. Target date retirement funds are a great option for just about all of us.
Do you agree with me that investing is actually not that hard?
Even though investing may seem complicated, understanding these terms should take some of that complexity away.
When you have a basic understanding of the key language, you’ll feel more confident in choosing an investment strategy that works for you.
That holds true no matter what direction you take. You’ll be prepared if you choose to talk to an advisor.
You’ll also have a head start if you choose to invest on your own.
So, what do you think?
Is investing really that hard?
Or, is investing actually the easy part?
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